Excerpts from Joint Committee on
Taxation staff's discussion of the nonqualified deferred compensation provision
included in Chairman Charles Grassley's (R-IA) mark of the tax bill now being
considered by the Senate Finance Committee.

K.
Inclusion in Gross Income of Certain Deferred Compensation Present Law

The
determination of when amounts deferred under a nonqualified deferred
compensation arrangement are includible in the gross income of the individual
earning the compensation depends on the facts and circumstances of the
arrangement. A variety of tax principles and Code provisions may be relevant in
making this determination, including the doctrine of constructive receipt, the
economic benefit doctrine,193 the provisions of
section 83 relating generally to transfers of property in connection with the
performance of services, and provisions relating specifically to nonexempt
employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)). In
general, the time for income inclusion of nonqualified deferred compensation
depends on whether the arrangement is unfunded or funded. If the arrangement is
unfunded, then the compensation is generally includible in income when it is
actually or constructively received. If the arrangement is funded, then income
is includible for the year in which the individual's rights are transferable or
not subject to a substantial risk of forfeiture.

Nonqualified
deferred compensation is generally subject to social security and Medicare tax
when it is earned (i.e., when services are performed), unless the nonqualified
deferred compensation is subject to a substantial risk of forfeiture. If
nonqualified deferred compensation is subject to a substantial risk of
forfeiture, it is subject to social security and Medicare tax when the risk of
forfeiture is removed (i.e., when the right to the nonqualified deferred
compensation vests). This treatment is not affected by whether the arrangement
is funded or unfunded, which is relevant in determining when amounts are
includible in income (and subject to income tax withholding).

In
general, an arrangement is considered funded if there has been a transfer of
property under section 83. Under that section, a transfer of property occurs
when a person acquires a beneficial ownership interest in such property. The
term "property" is defined very broadly for purposes of section
83.194 Property includes real and personal property other than money or an
unfunded and unsecured promise to pay money in the future. Property also
includes a beneficial interest in assets (including money) that are transferred
or set aside from claims of the creditors of the transferor, for example, in a
trust or escrow account. Accordingly, if, in connection with the performance of
services, vested contributions are made to a trust on an individual's behalf
and the trust assets may be used solely to provide future payments to the
individual, the payment of the contributions to the trust constitutes a
transfer of property to the individual that is taxable under section 83. On the
other hand, deferred amounts are generally not includible in income in
situations where nonqualified deferred compensation is payable from general
corporate funds that are subject to the claims of general creditors, as such
amounts are treated as unfunded and unsecured promises to pay money or property
in the future.

As
discussed above, if the arrangement is unfunded, then the compensation is
generally includible in income when it is actually or constructively received
under section 451. Income is constructively received when it is credited to an
individual's account, set apart, or otherwise made available so that it can be
drawn on at any time. Income is not constructively received if the taxpayer's
control of its receipt is subject to substantial limitations or restrictions. A
requirement to relinquish a valuable right in order to make withdrawals is
generally treated as a substantial limitation or restriction.

Special
statutory provisions govern the timing of the deduction for nonqualified deferred
compensation, regardless of whether the arrangement covers employees or nonemployees and regardless of whether the arrangement is
funded or unfunded.195 Under these provisions, the amount of nonqualified
deferred compensation that is includible in the income of the individual
performing services is deductible by the service recipient for the taxable year
in which the amount is includible in the individual's income.

Rabbi
trusts

Arrangements
have developed in an effort to provide employees with security for nonqualified
deferred compensation, while still allowing deferral of income inclusion. A
"rabbi trust" is a trust or other fund established by the employer to
hold assets from which nonqualified deferred compensation payments will be made.
The trust or fund is generally irrevocable and does not permit the employer to
use the assets for purposes other than to provide nonqualified deferred
compensation, except that the terms of the trust or fund provide that the
assets are subject to the claims of the employer's creditors in the case of
insolvency or bankruptcy. As discussed above, for purposes of section 83,
property includes a beneficial interest in assets set aside from the claims of
creditors, such as in a trust or fund, but does not include an unfunded and
unsecured promise to pay money in the future. In the case of a rabbi trust,
terms providing that the assets are subject to the claims of creditors of the
employer in the case of insolvency or bankruptcy have been the basis for the
conclusion that the creation of a rabbi trust does not cause the related
nonqualified deferred compensation arrangement to be funded for income tax
purposes.196 As a result, no amount is included in income by reason of the
rabbi trust; generally income inclusion occurs as payments are made from the
trust.

The
IRS has issued guidance setting forth model rabbi trust provisions.197 Revenue Procedure 92-64
provides a safe harbor for taxpayers who adopt and maintain grantor trusts in
connection with unfunded deferred compensation arrangements. The model trust
language requires that the trust provide that all assets of the trust are
subject to the claims of the general creditors of the company in the event of
the company's insolvency or bankruptcy. Since the concept of rabbi trusts was
developed, arrangements have developed which attempt to protect the assets from
creditors despite the terms of the trust. Arrangements also have developed
which effectively allow deferred amounts to be available to participants, while
still meeting the safe harbor requirements set forth by the IRS.

Description
of Proposal

Under
the proposal, amounts deferred under a nonqualified deferred compensation
plan198 are currently includible in income unless certain requirements are
satisfied. Distributions from nonqualified deferred compensation arrangements
can only be distributed upon separation from service, disability, death, a
specified time, change in control, or financial hardship. The deferred
compensation plan cannot permit the acceleration of the time of such payment by
reason of any event. Separation from service distributions to disqualified
individuals (as defined in section 280G) cannot be made earlier than six months
after the date of separation from service. Amounts payable upon the occurrence
of an event are not treated as amounts payable at a specified time. For
example, amounts payable when an individual attains age 65 are payable at a
specified time, while amounts payable when an individual's child begins college
are payable upon the occurrence of an event.

Disability
is defined as under the Social Security Act. Under such definition, an
individual is considered to be disabled if he is unable to engage in any
substantial gainful activity by reason of any medically determinable physical or
mental impairment which can be expected to result in death or which has lasted
or can be expected to last for a continuous period of not less than twelve
months.

Financial
hardship is defined as severe financial hardship of the participant or
beneficiary resulting from an illness or accident of the participant or
beneficiary, the participant's or beneficiary's spouse or the participant's or
beneficiary's dependent (as defined in 152(a)); loss of the participant's or
beneficiary's property due to casualty; or other similar extraordinary and
unforeseeable circumstances arising as a result of events beyond the control of
the participant or beneficiary. The amount of the distribution must be limited
to the amount needed to satisfy the hardship plus taxes. Distributions can not
be allowed to the extent that the hardship may be relieved through
reimbursement or compensation by insurance or otherwise, or by liquidation of
the participant's assets (to the extent such liquidation would not itself cause
financial hardship). Under the proposal, change in control will be defined by
the Secretary.

Initial
deferrals must be required to be made no later than prior to the beginning of
the taxable year that the compensation is earned. In the first year that an
employee becomes eligible for participation in the plan, the election can be
made within 30 days after the date that the employee is initially eligible.
Subsequent elections to delay the timing or form of payment can be permitted
only if the subsequent election is made more than 12 months prior to the date
of the scheduled distribution and provides additional deferral for a period of
not less than 5 years. A participant cannot be allowed to make more than one
subsequent election. No accelerations can be allowed.

If impermissible
distributions or elections are made, or if the plan or arrangement is amended
to allow for impermissible distributions or elections, amounts deferred are
currently includible in income. If the requirements of the proposal are not
satisfied, in addition to current income inclusion, interest at the
underpayment rate plus one percentage point is imposed on the underpayments
that would have occurred had the compensation been includible in income when
first deferred. Interest imposed under the proposal is treated as interest on
an underpayment of tax. Earnings on amounts deferred are also subject to the
proposal.

Under
the proposal, amounts deferred through an offshore trust are currently
includible in income. In addition, amounts deferred under a nonqualified
deferred compensation arrangement that provides that upon a change in the
employer's financial health, assets will be restricted to the payment of
deferred compensation would also be currently includible in income. The rule is
violated upon the earlier of when the assets are so restricted or when the plan
provides that assets will be restricted. Interest at the underpayment rate plus
one percentage point is also imposed on the underpayments that would have
occurred had the amounts deferred in an offshore trust or arrangement with
financial trigger been includible in income for the taxable year such amounts
were first set aside.

A
nonqualified deferred compensation plan is any plan that provides for the
deferral of compensation other than a qualified retirement plan.

Annual
reporting to the IRS of amounts deferred is required under the proposal.
Amounts deferred are required to be reported on an individual's Form W-2 for
the year deferred even if the amount is not currently includible in income for
that taxable year.

The
proposal is not intended to preclude the application of other rules that would
require earlier income inclusion. The proposal provides the Secretary of the
Treasury authority to prescribe regulations as are necessary to carry out the
proposal.

Effective
Date

The
proposal is effective for amounts deferred in taxable years beginning after December 31, 2003.

196
This conclusion was first provided in a 1980 private ruling issued by the IRS
with respect to an arrangement covering a rabbi; hence the popular name
"rabbi trust." Priv. Ltr. Rul. 8113107 (Dec. 31, 1980).